I caught up with a venture capital investor this week who shared that he’s raised a new fund in the last six months that’s over $1 billion, but he hasn’t started deploying it yet. He’s still deploying from his last fund. As he put it, the new fund is “on the shelf” for now. This got me thinking about the amount of dry powder venture firms are sitting on and how this dynamic affects the cycle of the venture capital business.

I went and found an old interview of Bill Gurley. Gurley said Howard Marks told him that venture capital can’t avoid cyclicality and is a boom-and-bust business model. Here are the reasons Gurley listed:

• A fund’s life cycle lasts a decade. Capital is committed, invested, and returned over in that period.
• The business has low barriers to entry and high barriers to exit.
• As markets begin to boom, capital floods in quickly.
• As the market breaks, capital can’t go away quickly. It’s stuck because it’s been committed for a decade.
• The vast majority of returns occur right at the end of the cycle.

VC is a boom-and-bust business model because of the way funds are structured. A boom is likely behind us. I wonder if the industry is ready for what comes next.

I’ve spent time working on understanding the journey of emerging investment managers. These people start companies that make money by investing capital. I think of them as entrepreneurs who happen to be investors, or “investor entrepreneurs.” I’ve been curious to learn how the most successful emerging managers are wired, so I started studying managers who’ve had outsize success over a decade or more. This means they’ve been able to compound their capital at an annual rate that exceeds benchmarks like the S&P 500. I started with venture capital fund managers but expanded to studying managers in private equity, real estate, hedge funds, value investing, and other areas.

Studying several managers who’ve compounded their capital at above-average rates in various ways has been enlightening. It’s shown me that the ways to have success as an investor vary widely. But I’ve noticed a trait that these successful managers have in common: a burning desire to approach investing in their own unique way as opposed to a way mandated by someone else. They wanted to develop, test, and refine their own investment approach. They saw starting their own firm as the best path. A few worked for other people, but that was never the goal—it was a stepping-stone. The goal was always to invest using a unique insight and control their own destiny as an investor.

Bloomberg published an article today entitled Shares of Startups Are Turning Dirt Cheap, Attracting Venture Funds. It contains some insights into the current state of the secondary market for start-ups.

A secondary sale is usually a transaction between two parties to exchange equity in later-stage start-ups. The start-up isn’t involved, except that sometimes it must approve the transaction.

I know a few investors, both individuals and institutions, who bought or sold shares on the secondary market in 2020 and 2021. Usually, it was a way for the buyer to get exposure to a company when they couldn’t become an owner in a funding round. The seller was typically an early employee, angel investor, or seed-stage venture fund. These investments were done at a valuation premium relative to the last funding round.

Things appear to have changed. According to the Bloomberg article, recent secondary sales have been done at steep valuation discounts relative to the most recent funding rounds. And there is increasing appetite by funds to buy on the secondary market and increasing desire by institutions such as pensions to sell private investments on the secondary market.

As more institutional investors, venture capital funds, and start-up employees seek liquidity when an IPO isn’t an option, I’m curious to see how secondary markets evolve.

Tiger Global is an investment firm founded over twenty years ago by Chase Coleman. Tiger has been investing in public and private technology companies for many years and has tens of billions of dollars’ worth of assets under management. It made waves in the venture capital industry for its investment pace in 2021.

Tiger closed a fund in 2021 that was reportedly $6.65 billion. And it closed on a $12.7 billion fund a year later (including $1.5 billion from firm employees, so $11.2 billion from outside investors) that took less than six months to raise. Read more about these funds and the firm here.

Last fall it was reported that Tiger was raising a new fund targeted at $6 billion. As of now, it has reportedly raised $2.7 billion, according to regulatory filings. (It’s still raising, and this figure could change.) Tiger’s ability to raise capital for technology investments has declined, and it’s not alone. Insight Global is a venture capital firm that reportedly has cut the target size of its latest $20 billion fund because of the challenging fundraising environment.

I don’t have inside information, and I haven’t talked to anyone at any of these firms or their LPs. But given rates paid on US Treasuries, returns required by LPs to justify illiquid venture capital investments are likely higher than they’ve been for ten years. Translation: LPs probably want venture capital funds to produce higher returns to compensate them for the risk of capital loss and the inability to access their capital for a decade. Combine that with the compressed multiples that technology companies experienced in 2022 (i.e., falling valuations), and fund managers are in a tough spot. They’re being asked to produce higher returns when exit valuations have come down (though this could go back the other way during the fund’s life).

This dynamic will likely have an impact on the venture capital industry if it continues. I’m curious to watch this and see how it plays out.

I chatted with a friend who’s in the process of acquiring a business. Instead of using a bank to finance the debt portion of the purchase price, he’s using seller financing. That is, instead of taking out a bank loan and paying the full purchase price in cash, he’s accepting a loan from the seller. The seller gets paid part of the purchase price in cash at closing, with the remainder repaid over time with interest.

This is common, but I hadn’t heard about it being used as much in the last few years because interest rates have been so low. I was curious how the seller felt about it, so I asked my friend.

He said the seller envisioned selling the business, getting cash in a lump sum, and riding off into the sunset. Seller financing, which prevents a clean break from the business, wasn’t part of his vision. It took a bit of convincing by my friend, but in the end, they made a deal after a detailed walkthrough of the math.

Riding off into the sunset is every founder’s dream scenario if they want to sell, but it doesn’t often play out that way. Things like earnouts and seller financing are common and can mean the seller will get delayed payments over a period of time.

I’ve been evaluating a potential investment and researching the industry. Today, I spent time with someone in my network who’s worked in that industry for over a decade. It took only an hour’s conversation for me to gain a much better understanding of the industry and its incumbents and get feedback on the value proposition of the company I’m evaluating.

Today was a reminder that you can’t know everything, and it’s helpful to have a network of people who can fill your gaps in various areas. Especially if you’re a generalist investor.

Howard Marks is a successful billionaire investor who cofounded Oaktree Capital in 1995. As of today, Oaktree has over $170 billion in assets under management, more than 1,000 employees, and offices worldwide.

Marks is known as a shrewd investor and for sharing his insights on financial matters in widely read memos since 1990. It’s said that many notable investors, including Warren Buffett, look forward to reading these memos.

I recently watched an interview in which Marks shared an interesting fact. Between 1990 and 2000, he didn’t receive a single response when he sent out his memos. Utter silence. People didn’t even acknowledge receiving them. But Marks continued to write them. After more than a decade, people began paying attention. Thirty years later, his memos are highly anticipated and widely read.

Marks’s memos are a great reminder that good things don’t always happen overnight. Marks put in consistent work for over a decade before his writing efforts began to pay off.

A few days ago, I chatted with a founder in the medical field who turned down a private equity offer to acquire his business. Today, a founder of an automotive business reached out to me and shared that someone in private equity inquired about buying his firm. Neither of these founders had their companies up for sale. The private equity firms found them.

These two stories are anecdotal, but they align with what I’ve been hearing from other investors. Large pools of capital have been raised by private equity to buy relatively small, profitable businesses.

Small businesses represent a great investment opportunity. Their size, usually $10m in annual revenue or less, means there’s ample room to grow revenue if their market is big. Their operations may not be very efficient and may rely heavily on the owner, so technology and better processes can enable these businesses to grow while increasing profit margins. Last, because these businesses are small, valuations are low because there are (or were) fewer potential buyers (i.e., less competition).

I chatted with an entrepreneur in the medical field who has built a business doing seven figures in annual revenue. He built the company from the ground up over the last decade and was recently approached by a private equity firm about acquiring his business.

He wasn’t looking to sell but decided to go through the process of having the private equity firm evaluate his business. In the end, the firm gave him a thorough analysis of his company and an offer to buy the entire company. He would have had to stay on, with a high salary, to continue running the company.

The founder did his own analysis and declined the offer. His business is generating a material annual free-cash flow. He concluded he’d rather own the business for the long haul than sell for a lump sum today because he’s built an asset that’s giving him an above-average return that probably will improve over time. He’d rather own a cash-flowing asset he controls with potential for increasing returns than take a lump sum and find other assets to invest in that will likely pay a lower return.

I enjoyed talking to this founder and hearing his thought process. I like the way he views his company as a cash-flowing asset and how he factored returns of his two options into his decision-making.

Yesterday I was at a social gathering. The topic of markets and investing came up because a few of the people there make relatively small personal investments in their spare time. The gathering included people from various backgrounds, locations, and professions, so I was very curious to hear what everyone had to say. I observed three notable points:

1. Negative sentiment – These people are interested in investing only in traditional cash-flowing businesses. This wasn’t surprising; I’ve heard the same from other investors and entrepreneurs. What stood out was the negative sentiment my friends had about start‑ups, technology companies, and to a lesser degree public equities. Their views applied to all start-ups and technology companies (excluding mega caps such as Google).
2. Historical trends – They expect certain asset classes, including real estate, to continue to perform well even in the current interest-rate environment.
3. Debt – They’re still embracing the use of debt to purchase physical assets.

Here are my thoughts on each point:

1. Sentiment about start-ups and technology companies may have swung from too optimistic to too pessimistic.
2. Understanding why a trend occurred in the first place is important. Then you can assess whether the same conditions still exist and gauge the probability of the trend continuing.
3. Everyone must make the decision that’s appropriate for their personal situation when considering whether to assume debt.

I enjoy going to social events that include people from various backgrounds and perspectives. I get a lot out of conversations at these events. It’s a great opportunity for me to understand how different people think about things.